Tame Wolves?

RISKY. EXTREMELY VOLATILE. Potentially toxic. Such are the criticisms routinely hurled at hedge funds. The truth, however, is that, at least in the past six years -- a period that included both a bull and a bear market -- they've stacked up well against stock-market benchmarks, both in performance and in volatility.

Hedge funds can employ a broad array of strategies, including buying and shorting stocks, using options and futures to offset or amplify positions, and sometimes bulking up bets with heavy doses of leverage. Some invest in the debt securities of bankrupt companies and play activist roles on their credit committees; others wager on the likelihood of announced mergers actually taking place, while still others purchase convertible debt and short the underlying stock, hoping to capitalize on pricing discrepancies between the two. This myriad of strategies gives hedge funds the ability to cope in just about any type of market conditions more easily than, say, a mutual fund whose charter limits its tactics to long-only investing.

Long favored by the wealthy -- to invest in them, one usually must pony up over $500,000 and meet certain net-worth requirements -- hedge funds in recent years have attracted big institutional investors, too.

The funds have fewer reporting requirements than mutual funds. Typically, they send out monthly statements and year-end financials to their investors, but under SEC rules don't have to publicly disclose their positions, as mutual funds must. This, along with their ability to short stocks, has led many people to view them as secretive and manipulative. That image has only been worsened by periodic accounts of shocking losses by one hedge fund or another and by reports that some officials, including New York Attorney General Eliot Spitzer, are investigating the breed. But, sometimes, a wolf turns out to be a lamb, and vice versa.

Interest in hedge funds has grown as stocks and equity mutual funds have foundered. Individual investors realize they can now get into hedge funds by making relatively small investments of as little as $100,000 in funds of funds -- funds that invest in a number of hedge funds. (My firm, Sandalwood Securities, advises funds of funds.)

As hedge funds become more available to smaller retail investors, they are increasingly coming to the attention of regulators. Are they in need of enhanced oversight? Maybe, but not because they're too dangerous for investors who already are accustomed to the roller-coaster returns of stocks and stock mutual funds in recent years.

First, some background. Hedge funds seek absolute returns; they're judged by whether they make or lose money. In contrast, mutual funds are the ultimate "relative return investments." Typically, Morningstar and Lipper, the mutual-fund industry's scorekeepers, judge their performance relative to that of an index such as the S&P 500, or a group, such as all large-capitalization growth funds.

Hedge-fund managers must clear a higher hurdle. Mutual-fund shareholders might be appeased (at least for a while) by being told that their fund's portfolio chief did a "terrific" job by holding the loss to 25% when the overall market was down 40%. But absolute-return investors would view such performance as bleak. As the saying goes: One can't eat relative performance.

Most investors don't realize that 80% or more of the return generated from long-only equity accounts usually results from market appreciation, rather than individual stock selection. It's no surprise that most mutual funds make money when the market goes up and lose money when it goes down. In the table accompanying this article, note the return of Fidelity Magellan -- one of the biggest, most popular mutual funds around -- and its correlation to the S&P 500, a proxy for the entire stock market.

Hedge-fund investors want their fate to be dictated by something other than the broad market's whims. If they can't make money in a bear market, like the one now pummeling Wall Street, they at least want to see their capital preserved, knowing full well how devastating a loss is for long-term performance. (In order to merely catch up after a 50% drop -- what a lot of stock-fund investors have suffered in the past few years -- what's left of a portfolio must rise 100%).

Have hedge funds been successful in their search for uncorrelated, positive returns? Not always, as anyone who held an interest in Long Term Capital Management, which almost collapsed five years ago, well knows. Nevertheless, the table, provided by London-based Financial Risk Management, a data-base company that also runs funds of funds, is quite revealing.

FRM, which tracks more than 1,000 hedge funds, has one of the industry's top databases. Its latest survey shows that, in the three years ended Dec. 31, 1999, the S&P produced a 27.56% compounded annual return. In the six years through Dec. 31, 2002, the corresponding number for the benchmark average was 4.40%. Similarly, Fidelity Magellan returned 28.03% and 4.25% in the same stretch, while the tech-heavy Nasdaq generated three- and six-year compounded annual returns of 46.62% and 0.57%. Talk about volatility!

During the three- and six-year spans, hedge funds' compounded annual returns were, respectively, 16.14% and 10.94%. So, hedge funds underperformed in the bubble, and have flourished in the bear market. In fact, they produced steadier, less volatile returns than did the long-only crowd.

Regulators should remember that when pondering what investments are too risky for some investors.

Martin J. Gross is president of Sandalwood Securities in Roseland, N.J., which advises funds of funds.

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